Déjà vu or Apophenia?

Last week I compared the current market downturn with that of the 1929 market crash. The main thrust of my argument was that a strategy of regular investment will still lead to above average long term returns, even if the market continues to emulate the Dow during the Great Depression.

Figure 1. Percentage change in the Dow Jones and ASX 200 following the highs of 1929 and 2007 (respectively).

An unintended consequence was that many readers mistook the similarity of these market trajectories as evidence that we were indeed headed for a repeat of the 1929 crash. While such observations can sometimes seem compelling, we should be careful to remember that all bear markets look similar – at least for a while...

If we adopt the usual definition for a bull market as a 20% decline in the benchmark index, then we have a host of possible comparisons that we can make. In fact, there have been around 10 over the past 40 years alone. In the chart below you can see how six of the more significant bear markets played out over the first 100 months.

Figure 2. Monthly change in value for the All Ordinaries following the most recent high prior to each bear market. Bear markets are labeled according to the year in which they started.

As you can see, one year after the 1987 crash it looked like the market was following the trajectory of the 1929 crash very closely, and by extension one could argue that it would continue to do so. But it wasn’t long at all before these two paths diverged quite significantly, as is seen below.

Figure 4. Monthly change in value for the All Ordinaries and Dow Jones following the most recent high prior to each bear market. Bear markets are labeled according to the year in which they started.

Similarly, a reasonable comparison could be made with the 1980 bear market and our current situation. As you can see, the bear market which began in late 1980 was very similar for the first 20 months. However, unlike the 1929 crash, the 1980 bear market in Australia lasted less than 2 years before the bottom was reached. Moreover, the market was back at fresh highs in less than 3 years.

Figure 5. Monthly change in value for the All Ordinaries following the most recent high prior to each bear market. Bear markets are labeled according to the year in which they started.

So what does this all mean? While the current market and economic reality is in some ways analogous to other historical periods, the fact is that it’s completely unique in its own right. Just as the Iraq war was similar to the Vietnam conflict in certain aspects, they were nevertheless also very different. In short, it is a mistake to assume that history always repeats exactly.

Figure 6. Monthly change in value for the All Ordinaries and Dow Jones following the most recent high prior to each bear market. Bear markets are labeled according to the year in which they started.

As an evolutionary adaptation, pattern recognition is a most valuable skill. The trouble is that it can sometimes back fire and lead us to see relationships that don’t actually exist. The phenomenon of falsely identifying patterns in random data is called apophenia and, given the ‘noise’ associated with market data, it is something that investors are particularly susceptible to.

We need to appreciate that the performance of various market periods will look similar until they don’t. The problem is we can’t know the timing or nature of the eventual divergence. All we can be certain of is that divergence will indeed occur at some point, and it has the potential to be very significant.

This may seem like a big problem for investors, but only if you remain focused on the specific. A focus on things such as the exact date of the market bottom or the day to day fluctuations of the market will only distract us from the bigger picture. The only justification you need to invest now is that you believe the market will be sufficiently higher at the end of your investment timeframe. For those looking to invest for the long term this has almost always been the case.